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Chapter 1-11

Financial Accounting Theory - Chapter 1-11 Textbook Notes

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Wilfrid Laurier University
Bixia Xu

Chapter 1 Historical PerspectiveValueinusediscounted present value of future cash flowsFair value exit priceopportunity costamount that would be received or paid should the firm dispose of the asset or liabilityObjective of financial statementsto provide information to assist investors to make investment decisionsStructured investment vehicles SIV o Created by lenders banks mortgages other financial institutions o Securitize holdings of mortgages credit card balances auto loans and other financial assets o Assetbacked securities ABSSIV pools investments into tranches of similar quality credits o Collateralized Debt Obligation CDOTranches of similar quality ABS tranches To further increase diversification o To obtain cash to pay the sponsor for assets transferred SIVs borrowed money by issuing assetbacked commercial paper ABCP that received high ratings from investment rating agencies and offered higher interest rates o Credit enhancement of ABS was necessary if the SIV was able to borrow at a lower interest rateLiquidity putsponsor agreed to buy back the SIVs asset backed securities if the market was to collapseRetention of the lowestquality tranche by the sponsor with various guarantees to reimburse purchasers for losses o Credit Default Swaps CDSSIV could hedge their risk by purchasing CDSsDerivative financial instruments that would reimburse the SIV for all or part of credit losses on its ABSs o Variable Interest entities VIESIVs under which the ownership interest varies with the fair value of SIVs net assetsPrimary beneficiaryMust consolidate its financial statements with the VIEs it sponsorsEntity that absorbed most of the VIEs expected losses and received a majority of its expected gainsExpected loss notesSponsors were able to avoid consolidation through thisSecurities sold by sponsors to outside partiesThe purchasers are contracted to absorb a majority of VIEs expected losses and receive a majority of expected net returns o Assetbacked securities lacked transparencyLiquidity risk oA risk of continuing decline in demand due to skeptical investors lack of buying o Can result in market value less than valueinuseLiquidity pricingo Outcome of liquidity risk o When market value is less than the valueinuse institutions feel like they would eventually realize a profit if they hold assets to maturity4 relevant points to accountants o TransparencyFinancial reporting must be transparentSo that investors can properly value assets and liabilitiesIncludes full reports of models used to determine value disclosure of any repurchase obligations and explanations of risk exposures and risk management strategies o Fairvalue accountingBased on market value or estimatesMay understate valueinuse when market collapse due to liquidity pricing that result from a severe decline in investor confidence o Fully reportedEncourages excessive risk taking by management o RegulationSubstantial changes to existing standards need to be taken placeConservative AccountingRequiring of higher standard verification to record gains than to record lossesResults in persistent understatement of assets earnings and shareholders equity relative to their current valuesUnrealized losses from declines in value are recognized when they take placeGains from increases in value are not recognized until they are realizedRulebased vs Principlesbased Accounting StandardsRule Basedattempt to lay down detailed rules for how to accountPrinciples basedattempt to lay down general principles only o Relies on auditor professional judgment to ensure that application of the standards is not misleadingEnvironment of accounting o Complexproduct of accounting is informationAbsence of perfect or true accounting concepts and standards o Individuals will not be unanimous in their reaction to the same information o Affects decisions and also the working of marketsInformation AsymmetrySome parties to business transactions may have an information advantage over othersAdverse selection o One or more parties to a business transaction has an information advantage over other parties o Occurs because someone might know more about the current condition and future prospects of the firm than outside investors o Can be adverse to the interest of ordinary investors because it reduces their ability to make good investment decisionsMoral hazard o One or more parties to a business transaction can observe their actions in fulfillment of the transaction and the other parties cannot o Accounting net income can be viewed as a measure of managerial performanceFundamental problem of FATCurrent value accounting o Must be reasonably reliable o Enables better investment decisions and betteroperating capital markets o Provides uptodate info about assets and liabilities hence future firm performance o Reduces ability of insiders to take advantage of changes in asset and liability valuesStewardship role of accounting o Provide info that is highly informative about managements performance in running the firm o Enables efficient compensation contracts and better working of managerial labor marketsOther Comprehensive Income o Includes gainslosses from adjustments to fair value of certain securities foreign currency translation adjustments some pension expense components etcMain problem o How to design and implement concepts and standards that best combine the investorinforming and manager performingevaluating roles for accounting informationTwo views as a solution o Keep regulation to the minimum needed to provide a stable environment for tradeLet market forces determine how much and what kinds of info firms should produce o Turn to regulation to protect investorsInfo is a complex and important commodity that market forces alone fail to adequately control moral hazard and adverse selection
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